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18 Jan 2022

Finance for the Start up space

Finance for the Start up space

 

We have all read headlines about this startup that was acquired for a billion USD or that got funded a 100 million and wonder why young companies are bought at such high valuations? Is it a gimmick? Are we back to circa 2000 when all one needed to do was to add a .com to the name of the company for its share price to zoom to nose bleed levels?

In short, our companies flush with cash from the success of the past 12 years repeating the mistakes that were committed in 2000. I certainly don’t think so because this time around transactions are happening because of visible factors like technological prowess, the number of users on the platform, a useful app, a niche site like Pinterest which used Facebook to attract users.

We will examine the typical factors that should form part of your checklist to make your firm that much more attractive for a potential investor.

What Drives Value?

Revenues, operating income margin, growth rate in revenues, reinvestment required to keep your firm running, tax rate, and cost of capital are the essential value drivers. The more customers you find who buy more from you on a sustained basis, the more the quality of revenue improves. Fluctuating revenues are like an inconsistent batsman, the selectors are not impressed with a flash in the pan. Operating Income Margin is the EBIT margin, the higher the better. An Increasing growth rate in revenues and operating income is a signal to the potential investor about the market prowess of your business idea, a falling rate in the growth rate suggests fatigue and valuations too will be modest.

Ideas that need to consume more cash than they spit out are an immediate no-no. No one wants to fund a white elephant with no prospect of turning cash flow positive. Tax Rate, although not directly under your control, can be planned in such a way that all the allowances, benefits, concessions, deductions, and eligible expenses under the Income Tax Act can be used to shelter the income from the taxman. We suggest the founder spend time reading an article on the subject written by CA. Lakothia.

Cost of Capital is the minimum acceptable hurdle rate the project has to earn to justify its continued funding to the investors; the more risky the project higher will be the cost of capital.

#1. Growth:

Growth in revenues, growth in operating income, growth in customer base, growth in asset utilization, and growth in operating cash flows are primary drivers of valuation. Not just the growth rate but the growth rate of growth rates (first derivative) is also observed to predict how sustainable the variables are, more sustainable more the valuation.

#2. Sustainable Growth:

A unique competitive advantage that cannot be imitated by an upstart competitor is the mote that increases valuation. The firm must preserve this secret sauce and get more and more people to use their product or patronize their services, that’s the key to sustainable growth

#3. Revenue Model:

The demographic profile of consumers and their buying behavior is analyzed to see how the revenue model will change with the change in underlying dynamics, today’s exotic Products may become plain vanilla products once the income or taste of consumers changes.

#4. Unique Design Capability:

One way to ensure we have a sustainable competitive advantage is to compete on quality and not on price because in a tough economic environment the firms that sell the cheapest get culled the first. Adequate financial muscle power is required to tide through rough financial weather. The unique feature in the product or customer behavior is essential to carve a niche in a difficult overly competitive market, so whatever you do ensure there is a sense of uniqueness about it.

#5. Reach:

The ability to reach out to a billion people is a sure way to impress upon them the need to use your product and services. Understanding who your customer becomes important, whether your service is aimed at businesses or end customers decides the leg work to be done to establish a communication channel with your customers. An example below will make itself explanatory:-

Value Drivers Before After
Ro Revenue in Zero yr. (Rs. in lakhs) 80 82.5
n Number of yrs of Supernormal Growth 5 6
m Operating Income Margin 18% 19%
T Tax Rate 34% 33%
gs Supernormal Growth 20.00% 21%
ds Depreciation Rate in Supernormal Period 6% 6%
capxs Capital Expenditure in Supernormal Growth Period 10.00% 10%
wcs Working Capital Expenditure in Supernormal Growth Period 5% 4.50%
waccs WACC in supernormal Growth Period 16% 15%
gc Growth Rate in Constant Growth Period 6% 6%
dc Depreciation Rate in Constant Growth Period 4% 4%
capxc Capital Expenditure in Constant Growth Period 5% 5%
wcc Working Capital in Constant Growth Period 2% 2%
waccc WACC in Constant growth Period 12% 11%
1+h Calculation ratio 1.0345 1.0522
1+h Calculation ratio 1.0345 1.0522
PV Hg FCFF Present Value of Cash Flows During High Growth Period 13 25
PV TFCFF Present Value of Terminal Value of the Firm (Rs in lakhs) 149 231
Value of the Firm 161 256
Increase in Value after Managing the Value Drivers 58.57%

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